Interest Interest is the amount addition to principal paid by borrower to lender per unit of time. It is paid by borrower because of different reasons. The reasons are
- Inconveniency due to lending: The lender feels inconveniency in lending. The lender will have less amount of money after lending some to the borrower. To compensate the inconveniency, the lender should obtain interest.
- Decrease in value of money: The value of money decreases with flight of time. The value of money lent is less during the time of repayment than during the time of lending. For compensating this too, the lender should get interest.
- Cost of keeping account: The lender keeps the account of money lent to others bearing some cost. In order to compensate the cost of keeping account too the lender should obtain interest.
- Risk in repayment: The lender feels risk in the repayment of loan even the lender will honestly repay the loan in time as per the terms of borrowing and lending. Against this risk in repayment too the lender should obtain interest.
- Sharing of benefit form the use of money: Borrower takes benefit form the use of money borrowed. Therefore, the benefits must be shared with lender in the form of interest.
Two concepts of interest
- Gross interest:
The additional amount over the principal the borrower pays to the kinder for all of the reasons is called gross interest. The gross interest includes the payment to the lender for inconveniency due to lending, decrease in value of money, cost of keeping account, risk in repayment and sharing of benefit form the use of money borrowed. Gross interest is the sum of net interest and interest paid and inconveniency due to lending, decrease in value of money, cost of keeping account and risk in repayment.
Gross interest = net interest + payment for inconveniency due to lending
+ payment for decrease in value of money + payment for cost of keeping account + payment for risk in repayment.
- Net interest:
It is the addition to principal only for the sharing of benefit form the use of money borrowed. For some economists, it is the payment for decrease in value of money too. It doesn’t include payment for cost of keeping account, inconveniency due to lending and risk in repayment. If we subtract the payment for there reasons from gross interest, we obtain net interest. Therefore, net interest is always less than gross profit.
Net interest = Gross profit – (payment for inconveniency due to lending
+ payment for decrease in value of money + payment for cost of keeping account + payment for risk in repayment)
Net interest = payment for of benefit form the use of money borrowed.
Net interest = payment for of benefit form the use of money borrowed + payment for decrease in value of money.
Classical theory of interest This theory is propounded by classical economists. It is also called real theory of interest. According to classical theory of interest, interest rate is determined by the real factors like demand for capital and supply of capital. The demand for capita means the investment. It is the demand for capital goods like equipments, plants, machines, tools etc which can be used for production of goods and services. The supply of capital means savings. It is the value of goods and services left after consumption out of the income. The interest rate is determined at the point of equality between investment and saving Mathematically, Equilibrium interest is given by Savings = Investment This theory is based upon following assumptions
- Money is veil and is just a medium of exchange
- Money is demanded or borrowed only for investment
- There is perfect competition in capital market
- Both demand for capital and supply of capital are determined by interest rate
Interest rate (r) Demand for capital (I) Supply of capital (S) 4% Rs 10 billions Rs 6 billions 6% Rs 8 billions Rs 8 billions 8% Rs 6 billions Rs 10 billions